The AMT Horror

The Alternative Minimum Tax (AMT) was originally designed to prevent extremely
wealthy individuals from skirting their income taxes. Unfortunately, the AMT has
grown into a tax trap that haunts millions of Americans each year. But with some
understanding and foresight, it is possible to make the AMT work to your advantage.

In the 1979 film The Amityville Horror,
George and Kathy Lutz (played by James
Brolin and Margot Kidder) are plagued by
various supernatural phenomena after they
move into a new house. Many American
taxpayers also find themselves beset by
mysterious forces when they try to
understand the Alternative Minimum Tax
(AMT) and the unpleasant twists it brings to
their finances.

The purpose of this paper is to explore the
background of the AMT and to provide
potential solutions for taxpayers in a variety
of situations so that they don't find
themselves surprised by an ?AMT Horror.?

The AMT started out very innocently as a
way to prevent wealthy individuals from
paying very little or no tax. But over the
years the AMT hasn't been adequately
adjusted for inflation, so the AMT affects
greater numbers of people each year. In
1970, approximately 19,000 individuals paid
the AMT. In more recent years, it is
estimated that between 2.5 and 3 million
people are caught in the AMT tax trap.

The AMT system is a parallel tax system.
While most individuals are familiar with the
ordinary income tax and deductions that are
allowed, you may find yourself crossing over
to the AMT system, a mysterious place
where the rules operate very differently. But
if you take the time to understand the AMT
and how it differs from ordinary income
taxes, you will find that it presents many tax
issues and opportunities. You might even
find a happy ending among all the horrors.

While one could take the time to figure out a
variety of different scenarios based on
various examples from the tax tables, our
experiences have shown that this is less
effective in illustrating the AMT, because the
AMT comes into play due to a wide variety of
different issues for each individual taxpayer.
In more recent years these individual
situations have been further complicated by
the fact that Congress has legislated lower
income tax rates, but the AMT has not been
adjusted for inflation since 1986. This
combination makes the AMT applicable to
even more taxpayers.

From a political standpoint, it would be wise
for Congress to adjust the AMT exemptions
and rates to reflect their current economic
impact and the number of people that are
being affected by this insidious tax.
Unfortunately, I feel that this is unlikely
because the AMT currently brings in a fair
amount of revenue, and members of
Congress who attack this problem run the
risk of appearing to favor the wealthy.
However, it is clear that the AMT has gone
far beyond the intent of the original tax policy
when it was first put into effect.

In order to understand the current effects of
the AMT, we will consider the tax from three
angles. First we will look at how to
determine your AMT and the applicable tax
rates. Next, we will examine the specific
issues that trigger the AMT and what to
watch out for in each area as you look ahead
to your tax year. Finally, we will consider
solutions that may be appropriate when
dealing with the AMT issue.

How to determine your AMT
Basically, the AMT is a two-tiered tax
structure. To determine the AMT, you first
need to calculate your gross income, and
then determine any applicable deductions.
Many of the standard deductions from
ordinary income taxes are reduced or
eliminated when determining the AMT.
These deductions and other factors will be
identified in greater detail later in this paper.
Once the applicable AMT deductions have
been subtracted from your gross income,
you can see if the AMT exemption is
applicable. The AMT exemption is
designed to exclude taxpayers with
modest incomes from the AMT, but the
exemption phases out for individuals
with higher incomes.

Once these items have been
calculated and you have determined
that you are not exempt from the AMT,
then your tax is determined by the twotiered
grade: 26 percent of the first
$175,000 of income and 28 percent of
the excess.

The resulting AMT calculation is
compared to the amount of your
regular tax and you are required to pay
the higher amount. The difference
between a regular tax and the AMT is
the amount of the AMT-specific tax.
This amount is important because you
may be eligible to receive an AMT
credit on future taxes. This credit can
be claimed on Form 8801. It requires
a third calculation of your income taxes
to determine the amount of available
credit, if any.

Issues that trigger the AMT
A wide variety of factors can cause an
AMT liability. If you are aware of these
factors during the year, you can look
out for events that may result in
additional taxes that aren't immediately
evident on ordinary income tax tables.
There are basically ten things that
have the potential to trigger an AMT
situation.

Personal exemptions.
The actual personal exemptions that you claim for
yourself, your spouse and your
dependents are not allowed when
calculating the AMT. It is actually
possible?believe it or not'to trigger
the AMT just by having a large number
of dependents in your household,
although it is unlikely.

Standard deduction.
There are a
number of taxpayers who claim the
standard deduction only because they
don't have enough other deductions
from charitable contributions,
mortgage interest, real estate taxes,
etc. But this isn't allowed under the
Alternative Minimum Tax. And so
when calculating the AMT, the
standard deduction is no longer
considered. As the margin between
the AMT and the regular tax rates
have narrowed, this alone has caused
many more individuals to face the AMT
problem.

Disallowance of state and local
taxes.
This area is particularly
troublesome in high tax states like
Minnesota where this deduction is
often significant and unavoidable. An
individual with lots of personal
exemptions, an expensive house and
a high income could be put into an
AMT situation automatically.

Interest on second mortgages.
You can deduct interest on mortgages
used to buy, build or improve your
home, but the interest deduction is not
allowed if you borrowed on the home
for another purpose. So home equity
loan financing that is no longer
deductible can act as a trigger for AMT
tax purposes. It's complicated further
in Minnesota in that the mortgage
deduction is denied entirely and does
not allow full charitable contributions.
5. Medical expenses. The amount
allowed for the medical expense
deduction is more limited on the AMT
than that allowed under the ordinary
income tax. If you have a large
amount of deductible medical
expenses, these could trigger the AMT
as well.

Miscellaneous itemized
deductions.
These are the
deductions that you list on the bottom
of the front page of your return if they
exceed more than two percent of your
adjusted gross income. They include
items like moving expenses, tax
preparation fees, and investment
expenses. They are not deductible
under the AMT.

Tax credits.
Certain tax credits
allowed under the regular income tax
are not valid when it comes to the
AMT. In other words, any tax credits
that may be coming from areas such
as childcare will not be factored in
when you calculate the AMT.

Incentive stock options.
This is a
huge area that can cause AMT
problems for individuals. The
difference between the market value
and the exercised price on incentive
stock options is included for calculation
of the AMT. When the difference is
large, this can cause a huge tax
liability that could force the sale of a
stock before it reaches long term
capital gains status.

It is important to consider the timing of
stock option purchases to make sure
that long-term capital gains status can
be reached if, in fact, the stock needs
to be sold in order to pay taxes. Longterm
capital gains have the same tax
rate under the AMT as they do under
the regular income tax system. So a
long-term capital gain under the AMT
calculation would have the same 15
percent rate as a long-term capital
gain under a regular income tax
calculation.

However, it is possible in this situation
that an AMT liability could come into
play because it reduces or eliminates
the AMT exemption amount designed
to help low income taxpayers. While
the tax rate on long-term capital gains
is the same, the loss of deductions
may trigger an AMT issue.

Tax-exempt interest.
Individuals in
high income tax brackets often use
tax-exempt interest to help reduce
their income tax.

However, many tax-free bonds are not
tax-free for AMT purposes. Examples
of these include industrial revenue
bonds that were issued by a
municipality for the use of a company
building by a private interest.

It's always important to check the
actual status of an individual issuable
bond if you are trying to avoid the AMT
with municipals, but general obligation
bonds are most likely to fit within this
category.

Also, if a municipal bond has a higher
interest rate compared to others, this
often indicates an AMT tax liability.
But in summary, even bonds that are
not AMT safe, have interest that can
be included for income tax purposes
under the AMT

Tax shelters.
Areas such as
intangible drilling expenses in oil and
gas drilling programs can also cause
AMT liability problems. Also, if you
have accelerated depreciation
schedules for equipment and/or real
estate, these can be added as income
for AMT calculation purposes.

Finding opportunities in AMT tax
liabilities
If you know that the AMT is going to
apply to you in current or coming
years, it is possible to take advantage
of certain situations. Too often a
taxpayer becomes aware of their AMT
liability when they are filing their taxes
and opportunities to mitigate the
situation have passed. Paying a
higher amount of taxes than you
expected is never pleasant, but the
AMT does present some opportunities
to recognize various taxable events
and improve your overall situation.

The positive part of this development
is that taxpayers with an AMT liability
have a maximum tax bracket of 28
percent. This may create an
opportunity to recognize taxable
income at the lowest rate applicable
for the foreseeable future. For
example, an executive with incentive
stock options may recognize that a
significant portion of non-qualified
options have a maximum tax bracket
of 28 percent in an AMT tax year,
rather than 35 percent. This
recognition of additional income raises
the amount of total tax but creates an
opportunity for a lower tax rate that
would not be available in a subsequent
year when the AMT liability isn't
present.

You also have an opportunity to
recognize other types of ordinary or
regular income during a year with an
AMT liability, such as the recognition
of gain in a deferred annuity. If you
have been avoiding the recognition of
that gain because of a 35 percent
income tax rate, the AMT liability gives
you to a chance to recognize it with a
28 percent rate, and an improved
investment vehicle may be chosen as
an alternative. The recognition of
more salary income in that particular
year could also be beneficial because
it's also taxed at a lower rate.

Claiming the AMT credit is another
important way to mitigate the situation,
as well as recognizing the amount of
AMT tax payable in previous years that
may be claimed in future years.
Payment of the AMT on a transaction
like an incentive stock option also
creates a dual basis in the stock that is
held. If you have paid the AMT on that
stock, recognition of the gain has
come into the AMT, and the ultimate
sale of the stock gives you a new basis
at roughly the exercise price on the
day of the transaction. Of course if an
AMT credit was claimed and retrieved
on calculation it will affect that basis as
well.

You might also take advantage of an
AMT tax event year by disqualifying
the disposition of some incentive stock
options, recognizing the ordinary
income gained in the year of the AMT
issue. This is particularly valuable
when the price of the stock is viewed
as fairly valued by the executive, and
recognition of the gain appears, or if it
seems unlikely that you will be able to
avoid the AMT any time in the near
future. It may also be valuable to try
and stagger the years when an AMT
tax event occurs. If you can plan for
an AMT liability in the current year, you
may be able to avoid it the subsequent
year, before it returns the year after
that, maximizing the options valued
before the expiry date.

Happy endings to the ?AMT Horror?
In summary, the AMT is not a pleasant
experience for anyone, particularly
when it catches you by surprise. But it
is possible to anticipate an AMT
liability and the potential opportunities
available with such a situation.

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